The equity risk premium (“ERP”) is the extra return over the expected yield on risk-free securities that investors expect to receive from an investment in a diversified portfolio of common stocks.1 It can also be thought to measure what investors demand over and above the risk-free rate for investing in equities as a class or the market price for taking on average equity risk.2
US risk-free rates are near historic lows due to the perceived low risk of US treasuries relative to the sovereign debt of other developed nations. Additionally, the Federal Reserve is undertaking quantitative easing and other efforts to lower interest rates in response to economic conditions. As a result, the capital asset pricing model (“CAPM”), which utilizes the ERP to calculate a cost of equity, currently implies a below-average cost of equity when the market is, in fact, considerably risky.
Research has shown that the ERP is cyclical during business cycles and that the ERP can fluctuate within its historic range based on current and forecasted economic conditions. The ERP tends to move in the opposite direction of the economy, so when the business cycle is at its peak, the ERP will be at the lower end of its historical range; conversely, during economic troughs, the ERP will be at the higher end of the range.1 The historical risk-free rate and ERP are presented in the following chart.
There is no single universally accepted methodology for estimating the ERP; thus, there is wide diversity in practice among academics and financial advisors with regard to recommended ERP estimates.
American Appraisal researched and analyzed various economic and market factors in order to determine where the current ERP should fall within a range of historical ERP. To determine which indicators were most relevant to the ERP, correlations were calculated for these indicators relative to the historical ERP. Long-term correlations greater than +/- 0.5 were considered meaningful.
Based on our research and analysis, American Appraisal utilizes a 6.5% ERP combined with the actual risk-free rate as of January 2013. Additional details of the factors we reviewed follow.
The factors determined to display moderate or strong correlations with historical ERPs were the CBOE Volatility Index (“VIX”), Damodaran’s implied premium, and Moody’s Aaa and Baa 20-year corporate credit spreads.
VIX is the ticker symbol for the Chicago Board Options Exchange (“CBOE”) Volatility Index, which numerically expresses the market’s expectations of 30–day volatility; it is constructed by using the implied volatilities of a wide range of S&P 500 Index options. The results are meant to be forward-looking and are calculated by using both call and put options. The VIX is a widely used measure of market risk and often is referred to as the investor fear gauge. There are three variations of the volatility indexes: (1) the VIX, which tracks the S&P 500; (2) the VXN, which tracks the Nasdaq 100; and (3) the VXD, which tracks the Dow Jones Industrial Average.
Damodaran’s implied premium, developed by Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University, is a forward-looking approach to calculating an expected ERP. It is based on using current market data to calculate an implied or residualized ERP.3
Moody’s Aaa corporate credit spreads are calculated based on the difference in Aaa corporate yields vs. US treasuries with similar maturities.
As described previously, the VIX, Damodaran’s implied premium, and Moody’s Aaa and Baa 20- year corporate credit spreads display meaningful correlations with historical ERPs. Each of the factors is briefly discussed below:
Damodaran’s Implied Premium
The six-month moving average trendline suggests that the implied premium is steadily trending down from 7.0% toward 6.0%. In addition, the actual implied premium for January 2013 has recently fallen to approximately 6.0%.
CBOE Volatility Index (VIX)
The VIX appears to be trending around its historical average (near 20), but has fluctuated considerably over the past few years, spiking to over 40 in 2011. Since the first quarter of 2012, the six-month trendline has recently begun to dip down below 20. Further, throughout the second half of 2012, the actual index has also fallen below 20.
Moody’s Aaa and Baa Corporate Credit Spreads (20-year)
Credit spreads have climbed slowly since January 2011. In 2012, Aaa and Baa spreads fell, rose, fell, and rose again, while their six-month moving averages remained relatively flat. The rise in spreads since 2011 may be a signal of increased risk or could be the effect of global risk in Europe causing flight to quality and creating anomalies in the US treasury markets. The most recent monthly data indicates a narrowing of credit spreads.
Additional Economic Indicators
In addition to the economic and market factors that display meaningful correlations with historical ERPs, the following economic indicators are monitored on a frequent basis to determine the current status of the US economy and help establish where the current ERP falls within the historical range.
Consumer sentiment trends, as tracked by the University of Michigan, indicate improving consumer sentiment, which is typically preceded by positive economic trends. The survey has indicated that consumer sentiment had recently risen from the beginning of June 2012 through October 2012. However, the survey has also indicated that consumer sentiment has declined from its 2012 high in October back down to its initial June 2012 level. In addition, the six-month average for consumer sentiment has steadily increased throughout 2012.
US Real GDP
The six-month moving average trendline for US real GDP indicates a relatively flat economy with slower growth trending toward 2.0%. However, during the second half of 2012, US real GDP again crossed above its six-month moving average trendline. This is considered a coincident indicator by economists and is neither leading nor lagging.
As the ERP is cyclical and can fluctuate within its historical range based on current and economic conditions, please consult with your American Appraisal valuation advisor when developing a weighted average cost of capital or, more specifically, the cost of equity.
1 Shannon Pratt and Roger Grabowski, Cost of Capital: Applications and Examples, fourth edition (New York: John Wiley & Sons, 2010), pages 115, 137.
2 Aswath Damodaran, “Risk Premiums: Looking backwards and forwards…” (presentation, October 2011).
3 Aswath Damodaran, Equity Risk Premiums (ERP): Determinants, Estimation and Implications - The 2012 Edition (paper, updated March 2012).
This newsletter is provided for general informational purposes only and is based upon the information available as of the time it was written. In addition, it is intended for US-based companies and may not be appropriate for companies with a significant share of revenues originating outside the United States.